China’s US Dollar Peg & Mercantilism Redux, Part 2

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Part 1of this three-part series laid the ground for an exploration of the effects China’s US dollar peg has on trade with the US and other nations and its global economic repercussions. While economists argue in support of and against China’s maintaining a fixed, or semi-fixed, currency management system, there’s no arguing that it contrasts sharply with those of its economic peers among the world’s largest economies.

Global economic conditions over the past five years clearly indicate that fundamental changes are needed if some sort of balance in the global economic system is to be achieved. Given the tremendous growth China’s economy has experienced in the past two-plus decades, and the repercussions of its US dollar peg, transitioning to a floating rate currency system could serve both China and its trading partners worldwide well.

Foreign Exchange and China’s Central Bank

In contrast to its peers among the world’s largest economies – the European Union (EU), the USA and Japan – where central banks maintain at least some independence from politics, a political body, China’s State Council, establishes and controls China’s monetary and foreign exchange policy, not the People’s Bank of China, its central bank.

One key aspect of China’s current monetary and foreign exchange rate policy entails strictly controlling and limiting the availability and circulation of foreign currencies to and among Chinese businesses and individuals. To do this, it buys nearly all the dollars, as well as euros, yen, etc., that Chinese exporters earn and exchanges them for yuan, or rather Chinese treasury securities in most cases. Issuing government debt obligations as opposed to currency helps limit domestic inflation.

The success of this policy, along with the great strides made by Chinese industry and commerce, has made China the world’s largest holder of foreign currency (forex) reserves. As it doesn’t just want to let them sit idle, it invests them conservatively, which has led to China overtaking Japan as the largest holder of US Treasury securities.

As of August 2011, China held $1.14 trillion of its $3.26 trillion in foreign reserves in U.S. treasuries, according to the Xinhua, the government’s news agency. This figure has grown enormously in the past decade. In January 2001, China’s US Treasury securities holdings amounted to less than $100 billion.

That has helped keep US interest rates, particularly longer and medium term interest rates, lower than they otherwise should have been or are. Positive as that may be, it obscures the more fundamental distortions and negative effects of its foreign exchange rate policy, and the fact that China’s economy operates under fundamentally different rules than its peers among the world’s largest economies. Hard times in the US, Europe and Japan have made it more difficult for policymakers, politicians and the public in those countries to tacitly accept the situation and continue allowing China as much leeway as has been the case.

The Dollar Peg, Chinese Savings and Investment

While China’s foreign exchange rate and monetary policy has served the Chinese government and economy well, especially when it comes to the export sector and employment in export-driven industry and manufacturing, it does have substantial costs, both domestically and internationally. At the corporate, business and individual level, Chinese savers are narrowly constrained in terms of the options they have to invest their savings.

That’s funneled savings into strictly domestic real estate development and stock market investment and speculation. These have grown tremendously in the past decade, which has resulted in rapid asset price inflation.

These are essentially the same combination of factors that led to the implosion of Japan’s economy in the early 1990s. Though the details vary to a greater degree, they also parallel the conditions that led to rapid asset price inflation and more recent boom-bust cycles in the US and Europe. As Chinese authorities maintained their focus on reducing inflation in 2011, the mega-rich property developers began to feel the pain and question their earlier assumption that Chinese policymakers would relent on their inflation fighting promises sooner rather than later. That’s led to some steep drops in property prices.

Reports of large property developers in Shanghai and Beijing drastically cutting prices on their huge inventories of unsold apartments have surfaced. That’s led existing owners, who paid much higher prices, to revolt, in some cases violently. Real estate policy-driven revolts have also occurred in rural areas. It may also lead to positive feedback loop, as growing numbers of property buyers seek to sell their properties before the bottom falls out of the market. This would lead to a sort of deflationary real estate ‘death spiral’ of the type experienced in the US in 2008-2009 and Japan in the early 1990s.

The Dollar Peg and Mercantilism Redux, Chinese-style

China’s economic growth and development policy can be characterized as an updated, central government controlled and Chinese form of mercantilism, which the U.K. employed in the days of the British Empire. It comes with other costs.

Maintaining the Chinese yuan-US dollar foreign exchange rate means it must hold more currency reserves on hand to intervene in the market to hold the dollar peg. That money is potentially capital that could be invested. It also means using that money to invest in foreign, in this case US dollar assets, not only buying US treasuries but companies, real estate, stocks and corporate and other bonds.

One of the key benefits of a floating exchange rate system is that automatic stabilizers are built into it. If the Chinese yuan were allowed to float, i.e. if international forex market flows were allowed to determine its value, it’s most likely that it would take a lot more US dollars to purchase a given amount of yuan than is the case today.

If China employed a floating exchange rate system as opposed to its current fixed, or semi-fixed, rate system, the value of the yuan would likely appreciate. Chinese goods would become more expensive, making goods produced in the EU, US and Japan cheaper. That should result in adjustments in trade flows, barring other actions or policies that would make foreign goods more expensive in China.

Focused on developing export-driven industry and manufacturing, strictly controlling foreign investments and strictly constraining forex and investment flows has proven to be tremendously successful for China. It’s also come at significant costs and created significant problems, both domestically and internationally. It’s led to historic, and still growing, imbalances in international trade and associated tensions. China’s trade surplus with the US hit yet another record high in 2010.

Economically, as well as in other important respects, China cannot be considered an international lightweight. It’s now the world’s second largest economy, the world’s manufacturing powerhouse, and its largest polluter. Yet it continues to receive preferential treatment as a member of the World Trade Organization (WTO), primarily because of the size of its population and its only relatively recent emergence as a ‘market-based’ economy.

These two factors led foreign businesses to practically climb over one another to find Chinese partners, establish operations and gain a foothold in China, accepting terms that they would never accept from any smaller, resource-poor nation. Recent hard economic times at home and their experiences in China have led them to reconsider these values and attitudes.

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